Curious Cat Investing Dictionary: Dollar Cost Averaging

Dollar Cost Averaging - An investment strategy to invest an identical dollar amount at set time intervals. For example, investing $100 each month in a mutual fund. This strategy results in you purchases more shares when the price is low and fewer when prices are higher (because the same dollars buy more shares when the price is lower and visa versa).

Here are two examples, if you invest $1,000 in a mutual fund and the price goes up every year (for this example the prices I used over 20 years: 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 22, 24, 26, 28, 30, 33, 36,39) you would end up with $40,800 and you would have invested $20,000. The mutual fund went from $10 a share to $39 over that period (which is a 7% return compounded annually for the share price). If you have the same final value but instead of the price going up every year the price was volatile (for example: 10, 11, 7, 12, 16, 18, 20, 13, 10, 16, 20, 15, 24,29, 36, 27, 24, 34, 39) you end up with more most often (in this example: $45,900).

You could actually end up with a worse return if the price shot up, well above the final price, very early on and then stayed there and then dropped in the last few years. Dollar cost averaging make a bad investment good, it just can help overal returns in some fairly common situations (markets that go up and down instead of just steadily going up (which many people psychologically would prefer).